What We’re Reading (Week Ending 28 January 2024) - 28 Jan 2024
Reading helps us learn about the world and it is a really important aspect of investing. The late Charlie Munger even went so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 28 January 2024):
1. Mark Dow – A Behavioural Macro View – Eric Golden and Mark Dow
Eric: [00:08:06] I appreciate you making the arguments here. The notion of the narratives, ones that I want to get into was the Fed. Since 2008, it feels like — the Fed was a topic of discussion. It seems to come and go and be more important to people. And it seems to be one of the central narratives that people go to. I’m curious on your view. You’ve talked in the past about the Fed might not have as much control as people give it credit for, but it sure gets a lot of the headlines as if it does have some complete control over which way the markets go every day.
Mark: [00:08:37] Yes. Well, first thing, it helps with content production. There are a lot of — CNBC and Bloomberg and a lot of people who produce content for a living, they need to say something. So the Fed is kind of the explanation of last resort, sometimes the first resort, but you always can point to something the Fed did and make a plausible argument that that’s what’s driving things. The second is when people are wrong, it’s much easier to say, no, listen, I would have been right in my bearish call, but the Fed cheated. They printed money or they did this.
Even now over the course of this year, as the Fed has shrunk its balance sheet and raised the interest rates by 500 basis points, people are trying to argue., well, this component of the balance sheet is changing, whether it’s the treasury, a general account or the reverse repo facility or whatever it happens to be, they want to say this is liquidity-driven because in a sense that exculpates their fundamental analysis that didn’t play out.
So it creates a lot of emphasis on it. But the big story this year and the one I’ve been talking about in our Behavioral Macro a lot, my subscription Twitter feed, is monetary policy didn’t turn out to be as powerful as everyone thought. And that’s where you made your money.
And there are three main reasons why monetary policy hasn’t been as powerful as people thought. There’s the behavioral reason, the secular reason and the cyclical reason. Just from a cyclical standpoint, we kind of know the story by now. We didn’t a year ago. And I got a lot of pushback on Twitter when I was talking about it.
But now I think everyone has recognized that the initial conditions matter a lot. The quality of the balance sheets in the household sector and the corporate sector and in particular, the financial sector were in much better shape than they were, the GFC, which is kind of the most recent memory people have, right?
So people have kind of been waiting for us to cyclically reproduce that cascading, deleveraging process that we had back then because that’s our PTSD, that’s in our memory. But the initial conditions were a lot better, and therefore, it didn’t happen.
And the recessions tend to happen when it’s about speed, much further level. So if you can deleverage — so basically, recessions happen when people get too far out over their skis taking risk because they got overly optimistic. And then for some reason, people say, oh, wait, I’m really out over my skis now, and things may not be playing out exactly what I thought, and they need to retrench.
So if they’re really out over their skis, they have to cut back on their investments rapidly, they have to fire people rapidly, households have to tighten their budgets, financial entities have to sell assets. All these things happen at once. And when they happen at once, it becomes self-reinforcing.
So if you go from unemployment of three to unemployment of six in two months, it panics people and leads to more layoffs at a faster rate. People go further and they don’t feel like they have the time or the luxury. And the same thing when they’re reducing the average on their balance sheets or households to cut back on their budget, that happens fast.
And then demand has cut back and then more people need to be laid off and it feeds on itself. It’s a self-reinforcing process until it burns out. If you go from 3% unemployment to 6% unemployment over two years, then it’s a more orderly process.
And you don’t get the fire sales and you don’t get the panics. That self-reinforcing feedback loop is a lot weaker, a lot less likely to get into recession. So that’s kind of how I look at this. And since our initial conditions were pretty strong, I didn’t think getting into one of those really aggressive feedback loops was very likely.
The secular reason is the Fed controls a lot less of money supply, if you want to call it that, than it used to. Over the past 30 years, we’ve had global financialization, global financial deepening, however you want to refer to it. And way back in the day, basically, the monetary system was the Fed and banks.
So the banks would issue credit and give you a deposit on the other side. So they would issue the money in the form of deposits into existence. That was the primary form of money creation, not the Fed, but the banks and the Fed supervised this process. They wanted to make sure that the banks were staying within regulatory parameters. They also had other objectives that they needed to fill.
What’s happened over the past 30 years, 40 years is we’ve had an explosion of things like repo and euro dollars. If you want to call them chattel banks or what have you, these guys also create money. When you do a repo, you’re basically liquefying an asset. You’re taking the asset on your books and you’re making it liquid by borrowing against it, and you take that money, and you spend it. That’s money creation.
Euro dollar is the same thing. Fed does not control these processes, not nearly as much as it controlled the system back when it was just kind of the Fed and banks. So a lot more of the system is beyond the reach of the Fed. And if you followed me at all on Twitter, you know that the price incentives using interest rate is a really, really blunt tool, right? It doesn’t always work that well.
And great examples of this are we have the biggest or at least the highest valuations in the stock market in my lifetime, probably ever, in 1999 and 2000 in the dot-com bubble when the Fed funds rate was 5% and 10-year was 7%, and we couldn’t even spell QE.
And we had the nastiest vintages of mortgages extended 2005, 2006, 2007, when the Fed funds rate was also around 5%, and we didn’t have QE. So it’s not as interest rate sensitive as people think. Because if you think you’re going to make 200% in a year or 300% over five years, whatever it happens to be, the difference between borrowing at 3% and 6%, it’s the same number for you. And that’s what happens. And also, when people are very fearful they become price insensitive too.
So just raising the interest rate — unless you go to really, really high levels, obviously, like Paul Volcker did. And within reasonable levels, it just doesn’t turn the dial that much on lending. Lehman had 33 turns of leverage when the Fed funds rate was at 5%. From a secular standpoint, the Fed just doesn’t control the money creation process nearly as much as it used to.
And then behaviorally, we’re all kind of conditioned to think that lower interest rates and higher interest rates have a really big effect. So we were kind of bracing for it. So everyone saw the Fed raised rates aggressively and that led people to say, okay, well, recession is coming for sure.
And we kind of had a precession where everybody saw the rates going up, they expected a recession was going to come in, but it wasn’t coming, but they started a little by little paring back and investing a little bit less, hiring a little bit less. We saw that the back orders for labor declined, all that kind of stuff.
So ultimately, that means people are less out over their skis as the process plays out. So you’re kind of deleveraging in a gradual sense. So we’re kind of braced for it because people will believe deeply that that’s what would happen, and then it didn’t happen.
Eric: [00:15:24] The way you think about the world, it feels clear. I think that for other people, it kind of breaks their brain a little bit that when you say in your example of the monetary policy of unemployment going from 3% to 6%, and the difference is it happens fast or slow.
If you had told people in advance — I think this is always still funding about hard markets are or how humbling they are. The Fed is going to raise rates. This is what’s going to happen. Many people assume this would be disastrous. It would cause a recession. The housing market would break. Like all these bad things would happen and here we are coming into the end of ’23, and I think every asset class is up in the face of that. So that kind of breaks people’s brains. Why do we get that so wrong?
Mark: [00:16:06] Well, I think these are the reasons I was just talking about, people overestimate the power of monetary policy. And they thought the inflation that we had was much more monetary than it wasn’t monetary at all. It was obvious entirely COVID. It was fiscal but people — they have this — we were trained. Milton Friedman said that kind of mindset, people think the high-powered money and the loanable funds model, none of which only worked that way.
Like I said, banks issue money into circulation via deposits. That’s how the bulk of money gets created. In exceptional circumstances, the Fed can expand and contract its balance sheet because there’s a demand for liquidity. So whenever it wants to deleverage, banks need a lot of dollars for settlement. They need to settle with each other.
So the demand goes up a lot like back in the day when we were more agrarian economy and the Fed around harvest time had to produce big boxes of money and send them out to the hinterland so that transactions could get done. The Fed provides the elasticity in the monetary system for rapid expansion and contraction of demand for cash. That’s kind of their role and the banks are supposed to issue the dollars into circulation via credit.
Most people don’t get that. Once you get it, once you understand endogenous credit, then things make a lot more sense to you, but the wrong model has been drilled into people’s heads so thoroughly and it makes a much intuitive sense that people — even though it’s wrong, that it’s hard for people to get past it.
Eric: [00:17:26] So if people are looking at — if they’re looking at the wrong way, when you get something like quantitative easing, quantitative tightening, this idea that the Fed could impact the market and even more powerful, the irony is what you’re saying is so not a consensus, which is why I love it that coming out of 2008, it was the Fed was even more powerful than they’ve ever been before and that they have the implication on the market. So if the QE isn’t really whatever one thinks it is, is that because it’s really just moving money between the banks and the Fed
Mark: [00:17:58] Yes, basically. I mean, the way the mechanics work, you can call it printing money, and I think that leads to a lazy thought process because some people kind of take it literally unless you press them to go, oh, it’s not literally printing money, but really, it’s just an asset swap.
So think about it in the simplest way possible. You have a 60-40 portfolio. Just — to make it simple, your 60% is in an S&P ETF, and your 40% is in T-bills. So you got your risk money, your 60%, and your risk-free money, you’re ballast as it were. So the Fed comes in and they buy all your T-bills, and they give you a deposit at the Fed, which yields roughly the same thing.
Are you going to change your 60-40 allocation because of that? Are you going to go out and buy Tesla stock with that money? Not unless something else changes in your mind and you think you need to take more risk, which is possible, but it’s a totally separate decision.
But that’s what really happens. The Fed liquefies the system and allows for settlements to take place amongst themselves. Now the way QE is supposed to work in theory, and I think a lot of the people who put it in place way back when, if they were to review what happened now, they would say, okay, it didn’t hurt, but it was a lot less powerful than we thought it might be. It’s supposed to work in two ways.
One is what they call the portfolio rebalancing effect. And that is Fed buys bonds, takes them out of circulation. The people who own those bonds, say, I should probably replace that duration in my portfolio, so maybe I’ll buy some government-backed mortgages. So same risk temperature more or less, but it’s a little bit — just a hair out the risk spectrum. And some guys might say, well, yes, I’ll buy some high-grade debt, some high-quality corporate debt, a little bit further out the risk spectrum.
But you also have to keep in mind that most of the people from whom the Fed is buying these bonds, it’s not in their mandate to go out and buy equities, right? They’re buying it from like PIMCO. They’re buying it from fidelity bond funds, and they’re buying it from these guys who have a very clear mandate, and they don’t buy equity.
So that kind of effect is not that strong, first of all. I mean it’s kind of there, but it’s indistinguishable from the natural process of people moving out the risk spectrum with time. And we can talk about that later because it’s a super important point, how risk appetite works over the course of a cycle. This marginal effect is really indistinguishable from this bigger effect, I think, of people over time moving out the risk spectrum during a cycle until we get to that point where we are too far out over their skis, and we have to bring it back.
The second channel is the idea that by taking duration out of the system, it will lower the yields on bonds and that will stimulate lending and things like that. But as I like to say, you can lead a banker to liquidity, but you can’t make it lend. You need the risk appetite for people to lend.
And it’s not even clear how much QE lowered interest rates because we know from a flow standpoint, during QE1, QE2, QE3, every time these things got rolled out and the Fed was buying bonds, the yields were going higher, and they were going higher primarily because of the placebo effect. People believed that the Fed intervening was protecting the downside on the economy.
And therefore, they said, okay, I’m selling bonds and I’m buying equities. That behavioral effect based on perceived change in economic outlook was much more powerful than the mechanistic buying from QE. And this is why I was saying back in September, I said as soon as we get a whiff of slowdown in the economy and inflation cools off, all this talk about supply and fiscal unsustainability is just going to disappear, which is exactly what happened.
So it’s not that these effects don’t matter. It’s — they get swamped by changes in demand triggered by changes in the economic outlook, our perception of growth. So from a flow perspective, it didn’t work. In fact, it worked the other way. Yields tended to go higher when the Fed did QE.
So does it work from a stock perspective? If they buy enough bonds and take them out of circulation, it drives interest rates down? Maybe a little bit. But it’s really hard to say. Look at what’s happened now. We’ve — the Fed balance sheet is down by $1.3 trillion.
So whatever people say about repos or the TGA, the Fed owns $1.3 trillion less of securities, of bonds and mortgages. And we’ve raised rates 500 basis points. And for sure, the 10-year treasury has not gone up 500 basis points. It’s gone up by a lot less than that.
So it’s hard to argue that anything other than economic expectations is the primary driver, yields further out the curve. So it was an experiment worth doing, and a lot of people don’t get this. The first QE was really about the plumbing. They were trying to make sure that the pipes worked, that markets didn’t get gummed up, that things could work smoothly. It wasn’t about, at least the first two-thirds of it, wasn’t about trying to boost economic demand or activity, that came later.
But what QE unambiguously does is in times when there’s a surge in demand for transactional balances like back in the agricultural days when they shipped out those boxes, the Fed provides the elasticity to make sure the payments can flow through the system and the dry cleaner in Cedar Rapids can make payroll. That’s kind of how it’s supposed to work.
But it’s just not very powerful when compared to the changes in economic outlook. This is why supply rarely — and people talk about bitcoin and fixed supply. What matters is demand. Demand is really what swings and supply is rarely the issue. That’s why QE and Q2 are — this is my second time through it.
So I still have the scars from 2008 telling people that QE wasn’t going to cause inflation, and people looked at me like I had 3 eyes, and I remember I was working at hedge fund, we lost a client because of that and a couple of prospects.
I remember one guy telling after having a meeting — I used to get sent to a lot of the meetings because I was good at explaining the economics and a lot of the guys I worked with were flow traders who are maybe not as articulate and kind of had intuition and good risk management, but couldn’t explain things as well to clients.
And I remember explaining the things to a particular client, and afterwards, I heard from the owner of the hedge fund, he came back and he said, “This is what he said, Mark,” he was laughing about it. He said, “Mark is really smart, but he’s just going to get you guys killed with his view on inflation,” and they ended up not investing with us largely for that reason.
But anyway, I’ve been through this a couple of times, and I just retweeted a tweet today that I sent out back in August. You know the depth of the market in August of 2022, saying, if we get to all-time highs anytime within the next 12 months or by the end of 2023, we can eliminate, for sure, the QT effect that so many people fear. And that was kind of peak fear of QT because the market was going down and a lot of people ascribed it to QT. It just doesn’t have that kind of effect.
Eric: [00:24:32] The thing that I remembered was during ’08 when it was going down and being so close to the center of it all, you realized how bad it was. And the reason why — I have two parts here. One is I do remember when QE first happened, it did feel like — and maybe the Fed still has this power that when the system seizes up, it really is the only thing that can reliquefy the system that it has this power to say — if the Fed didn’t step in, in a way, I felt like it would have been significantly worse.
But then after it happened — this is the second part of that question. I remember something like 40 of the greatest investors of all time because I was early in my investing career. I think I’ve been there for about three or four years. All of a sudden, we see the world collapse and then they unleashed this thing, which it felt like it’s saved everything.
It truly felt like it worked, but nobody knew the ramifications. And the smart money — there was this Wall Street Journal article, where 40 of the top hedge funds said, we’re going to go into inflation because of this, because we just unleashed like Pandora’s box. So why are you so confident at that moment.
Mark: [00:25:34] Yes. It was 2010, and I looked at the list, and there are a lot of prominent economists on there and investors and I remember Cliff Asness was on there and Jim Chanos and other names that guys on the Street would recognize. And I was confident because I knew how it worked.
And my time at the IMF, I climbed into so many different central banks and economies, I got to understand the plumbing in a way that most theoretical guys don’t and most Wall Street guys don’t. They kind of gloss over this and they said they had someone summarize Milton Friedman for them, and they think they understand monetary policy. This has been an eye-opening experience for a lot of people.
But if your balance sheet is broken, it doesn’t matter how much liquidity the Fed provides. You’re not going to lend it out, you’re going to fix your balance sheet first. That’s just common sense. And the mechanics don’t work that way anyway. That Fed doesn’t give you money and you lend it out.
Like I was saying earlier, the way it works is the bank makes a loan and then gives you a deposit and their limits are governed by the regulatory framework. They have capital requirements. They have liquidity requirements. They have leverage requirements. They have to stay within those.
But the banks are chartered to issue money, create money through deposits. That’s how it started in 1863 with the National Banking Act. The Fed came in 1913 and started to supervise the process because it became clear that the banks weren’t very good at it either. The banks aren’t going to be taking risk in creating deposits and issuing money if their balance sheets are busted. That for me was just the easiest.
And listen, everybody talks about the power of interest rates, but we had 0 interest rates, and we had ZIRP and QE for four, five years before people started taking any risk at all because you have to fix your balance sheet first. Maybe this is the right moment to talk about it, but risk appetite is driven much less by the price of money than it is by the other factors.
And the two factors can really boil it down to something easy to communicate. The two factors are — I call JPMorgan’s famous quote where he says, “Nothing so undermines a man’s financial judgment as seeing his neighbor get rich.” That means once your situation is okay and you see people around you making money, you say I’m going to make money, too. And then you end up with a stripper in Florida that owns five homes with Megan Mortgages, and the system blows up.
So that’s how it tends to work. We look around — prices go up a little bit and we look around, we see other people making money, then we take a little bit more risk and we see prices go up more. This is why, as I said earlier, nothing brings out the buyers like higher prices. That’s really how Wall Street works. Now from a macro standpoint that matches that is Hyman Minsky’s financial instability hypothesis, and it’s basically stability breeds instability.
So it’s kind of the same thing. Everyone starts making money. The banks look around their [indiscernible] to keep up with Goldman Sachs, and they start underwriting riskier mortgages and everybody starts doing it. It’s not because they think the Fed is going to bail them out or anybody is going to bail them out. No one is going to make a loan apart because I think the Fed is going to come in at $0.40 on the dollar and bail them out. No one wants to take that loss.
What happens is the optimism and the greed blinds people to downside risk. Anybody who’s been in the room, and I have been in these rooms, right, over my career with the risk committees and how people are making these risk decisions, it’s not because they miscalculated the downside, but I think they’re protected somehow since they’re ignoring it. Their greed and their competitive pressure leads them to take too much risk.
I remember Stanley Mack from Morgan Stanley shortly after the Global Financial Crisis was being interviewed on a Bloomberg forum. He told the story of a client of his who’s a good friend and a long-term client, called and asked for a loan and Stanley Mack said, I can’t do that. It’s just not responsible. It’s too much leverage or whatever the reasons were. He said it wasn’t the right thing to do.
And this was the guy whom he had a really good relationship, long term, both personally and professionally. And he said, as soon as I hang up the phone, I knew he was going to Merrill Lynch to get that loan, and he did. So it’s really the competitive pressures and being blinded by greed that leads people to take all the risks, not because they think their downside is protected.
And Hyman Minsky kind of says, all these things end up — when you’re stable, people start taking a little by little more risk, and then you end up — it ends up bringing instability because in a capitalist system, we take things too far. And we should. That’s how we get innovation. We’re supposed to be taking risk, and we’re supposed to be failing.
The Fed’s job is not to stop bubbles and keep us from doing it. The Fed’s job is to make sure that the guardrails of the regulatory system are in place so that collateral damage on to innocent people doesn’t happen.
And this is what they did when you were saying earlier, they stepped in and they flooded the system with a settlement liquidity so that everyone’s transactions could clear and so that you and I didn’t have to go out in our pajamas at three in the morning, waiting in front of an ATM machine in line, hoping that there’d still be money in there when we get up in the front of the line.
2. This Is What’s Driving the Big Surge in US Oil Production – Tracy Alloway, Joe Weisenthal, Stacey Rene, and Javier Blas
Javier (03:15):
We had record levels, and it’s just an incredible number. As Tracy said, if you look just at what we say is ‘crude oil,’ it’s more than 13 million barrels a day. But if you add on top of that number other things that go into the oil, liquids streams or condensates and NGLs (natural gas liquids), a bit of ethanol, etc., etc. — we are well above 20 million barrels a day of oil production that compares to a hundred million worldwide.
So you put everything together, the US is producing one in five barrels of oil consumed. That is just an incredibly high number. And it doesn’t seem to be stopping. Probably it’s going to slow down a bit in 2024, but it’s going to continue to go up.
Tracy (04:04):
Okay, where is all that new oil actually coming from? Because it’s been a while since I’ve brought up the rig count chart. But if you look at the rig count chart, this is such a fun one because you can see the big humps of the early 2010s and then the big slide into 2015, and now it seems kind of flat. So there’s been some increase between 2020 and 2022. The number of new rigs being drilled has gone up, but it’s not like we’re seeing a boom in new gas rigs and new explorations. So where is all this oil coming from?
Javier (04:43):
Well, it’s coming from the very same places that it was coming about 10 years ago, but it’s coming in some way, and for lack of a better word, better. So it’s coming from Texas, it’s coming from New Mexico, and it’s coming a bit from North Dakota, Oklahoma, etc., etc. It’s coming from the shale regions of the United States.
But if we were to say ‘where’ in just one single or two, or in this case, three single words, it’s Texas and New Mexico. That’s where the new oil is coming. And you are right Tracy, the recount is not significantly up. Actually, you look at [it] from a loan perspective, it’s lower than it was during the previous booms of shale.
But it’s just that the oil companies in Texas and New Mexico have [gotten] very good at extracting more oil from those rigs, from those wells that they’re drilling. And they’re also doing much longer wells. If you think about how a shale oil well looks like, it first goes down vertically and then it just turns around 90 degrees and it goes horizontal for a while. At the beginning, those horizontal wells were relatively short. Perhaps a quarter of a mile, half a mile at most. Now they’re going as much as three miles horizontally. They can get a lot more oil than they were able to do a few years back…
…Joe (07:04):
So that really held up well. So what’s changed since 2016 Javier? Tech?
Javier (07:09):
Technologically-wise, we can drill longer, particularly the laterals. We can pump fracking fluids at a higher pressure. And companies are also very good at doing this super quick. Previously our well could have taken 30 days — now it takes 10. Companies and the crews have gotten very good at doing it. And that means that they can do it cheaply. And that’s the funny part of the whole boom of 2023 and 2024, a difference of the previous ones. Companies are making money and investors are making money. So everyone is loving it. This is the first time, and this is what really terrorized OPEC, that shale oil is growing and making money at the same time. And that’s a big problem if you are in Saudi Arabia.
Tracy (07:56):
Definitely want to get to the possible response from OPEC. But just in terms of technology, one of the things, and the reason I brought up that story, was the idea of standardization. So,before you used to have all these bespoke custom fittings for oil rigs or platforms or whatever. But then, I think there was actually an industry-wide effort or attempt to start standardizing some of these things so you didn’t have to order a bespoke component for every single oil project that you were doing. And that seems to have helped make things go faster — to Javier’s point and also brought down costs. Javier, how much of a big deal is that in the industry?
Javier (08:36):
It is a big deal. It has happened everywhere in the oil industry. Let me give you my favorite anecdote of a standardization in the oil industry. So you are working on a North Sea oil platform, this is offshore outside Norway and the United Kingdom. You need to paint a lot of the stuff yellow, kind of yellow [for] danger, very visible etc., etc. Very stormy areas of the wall. The North Sea fog, it’s not the kind of place that you really want to spend an evening in winter there.
So every company has their own shade of yellow. There were 19 different kinds of yellow to paint things in the North Sea. Each company has their own shade with their own specification, and it was just ridiculous. So at one point, a few engineers in the industry got together and said ‘Well, this is a bit ridiculous. I mean, can we not just do a yellow North Sea?’
And so they got together and everyone decided this is the shade of yellow that we’re going to use. And now everyone is painting everything that they need to paint in yellow with the same shade. That at a much bigger scale has happened across the oil industry. Everything has got a standard. And companies within themselves, they like to do everything bespoke. They really, in some way, gold-plated a lot of projects. So each well was a bit different to the other one. Now, companies are designing one single design. And when they have really thought ‘Okay, this is it. This really works very well, now copy and paste for the next 25, 50, 100 wells’ — that has cut costs significantly…
…Joe (10:39):
Yeah. They’re all looking at the different Pantone shades, but got to do so in a legal way. All right, let’s talk about the capital markets aspect because it did seem like, you know, the way people thought about it was that the industry had to face a choice. Would it be pursuing volume or would it be pursuing profitability? And as you’ve just said, there seems to be this very weird situation in which volume is ramping and productivity is sustained. How is that happening and how sustainable is that?
Javier (11:06):
Well, to the question of how long and how sustainable — I’m going to be honest, I don’t know. I thought that production growth would have a slowdown in 2023 and it never happened. It did the opposite, it accelerated. You look [at] every oil executive, if you look at the forecasters of the industry, everyone is saying it’s going to slow down in 2024. But also they said the same for 2023, and they were wrong.
So we’ll see what happens, really. But yes, I mean the industry went into this new era thinking about profitability. So everyone cut CapEx, everyone tried to get more efficient. And everyone thought that production growth was going to slow down because the focus was profitability. The fact that they were able to grow quite strongly came [as] a bit of a surprise to the industry. And then everyone kind of celebrated it.
But here there is a very important question. If OPEC has not cut production to make room for all this new shale oil from the United States, prices will have come down. And then the industry would have faced the same kind of dilemma of the past. You are producing too much, then the prices come down, your profitability comes down, and then you have a problem. So a lot of these that we are putting based on efficiency, it’s true. But if not for OPEC cutting production and keeping prices above $70 a barrel, then shale companies will be in trouble.
Tracy (12:47):
One thing I’m really curious about is who is actually funding production now versus, say, in the early 2010s.
Joe (12:56):
And just to add onto that a little bit, is there any difference between private and publicly-traded domestic US players?
Javier (13:02):
Okay, so let’s in parts. On Tracy’s question, who is funding this? Well back 10 years ago, five years ago, it was Wall Street. It was a mix of equity and credit markets which were funding all of this growth through different instruments. I mean sometimes it was just issuing fresh equity. Sometimes it was bonds, high-yield bonds, reserve lending where a bank is lending to an oil company based on the reserves underground; more or less like a mortgage rather than a house. You mortgage the oil reserves that they’re underground.
And a lot of that is still there, but a lot of the money now needed for the expansion and to finance all this new growth is coming from cash flow generation. It’s the internal cash flow of these companies. They generate enough cash to pay for all the new drilling that they’re doing to pay for all the capital investment that they need to do alongside new pipelines, etc., etc. And to pay the shareholders.
These companies now for the very first time are paying dividends. And that sounds like — well, publicly-listed companies should be paying dividends that’s like normal. Well, that was not the case a few years back. But now they generate enough cash to do all of the above.
And in terms of is there a difference? Yes. Publicly listed companies have been a bit more cautious, they have been trying to. They have the shareholders, they have Wall Street on top of them, and they have to really try to focus as much as possible on paying dividends and buying back shares. Publicly-owned [companies] don’t have that pressure, that super strong pressure. So they have done a bit more growing. And there is a suspicion in the industry that a lot of that growth was to try to maximize the amount of production that you are doing so you can sell yourself to a big player, say ExxonMobil or Chevron. And perhaps that’s not as sustainable as it looks like…
…Joe (21:02):
I think his name — he even wrote a Bloomberg Opinion column on March 20th, 2020 – Ryan Sitton was his name. The railroad commissioner who called on OPEC to coordinate with the US in constraining supply.
I want to pivot for a second and talk about the Red Sea. And we talked about it a couple weeks ago in the context of container freight. What [causes] the rising tensions there? We recently saw the US strike at Houthis assets. What does the rising tension there mean from an oil perspective?
Javier (21:34):
Well, it’s more or less a binary situation. As long as the strait of Hormuz, which is the big outlet from the Persian Gulf for countries like Kuwait or Saudi Arabia into the open markets, as long as that remains open, what’s happening on the Red Sea is of less importance. Yes, it’s going to mean an increase in cost because a lot of the oil tankers and also the LNG carriers, these are liquefied natural gas carriers. They’re going to have to divert, avoid the Red Sea and go around Africa. That adds from the Persian Gulf into Europe probably a good 10 to 15 days extra. So it is not small and it could really increase the cost of shipping, but it’s not the end of the world. And that’s why the oil market is taking it quite relaxed.
I mean, prices have barely increased over the last few days. But then you could think ‘Well, that is basically on a scale of one to 10, probably a two, maybe a three.’ What is the other scenario? Well the other scenario is the open fight with Iran, not with his proxies — the Houthis in Yemen — but actually with Iran and the strait of Hormuz somehow gets in trouble. Shipping is more difficult though it probably is not completely closed, but things get really bad. And that on a scale of one to 10, that’s probably 25. And that’s the problem. That’s what I say, it’s a bit of a binary situation at the moment. So far not so bad…
…Javier (27:19):
I think that you are putting it absolutely right. I mean, the fact that the US is exporting so much oil, and when you count crude and refined products, many weeks, the US on a gross basis is exporting more than 10 million barrels a day. Obviously at the same time, its importing a bit. So on a net basis, about 2 million barrels a day.
But the fact that the US has oil to export on a net basis more than it consumes and it can export is just mind blowing. And particularly, you know, I have been writing about this industry for 25 years. If even 10 years ago you had told me that the US was going to be exporting the amount of crude that it’s doing today, I would have said absolutely not. No way. No way this is happening…
…Javier (30:16):
Well, it’s particularly about how we trade electricity. And you think about a few years back — and by that I mean five, six years ago — a lot of the electricity market in Europe was controlled by the typical names that we all knew. The utilities that have been privatized, but used to be state-owned companies, big names like EDF (Électricité de France), RWE, etc., etc.
And the market was quite sedated. Prices were not really moving much. There was not much volatility. There were very few of the independent traders really making money trading electricity. And a few years back, in the middle of nowhere, Denmark, in a town called Aarhus, it’s a big university town in rural Denmark, a group of companies kind of started to plot how we can make money out of this market.
And they were really driven by two things that were happening in Europe. It was the liberalization of the markets. There was a lot more cross-border electricity trading in Europe. And there was also a lot more volatility in the supply of electricity in Europe because of wind and solar.
You cannot predict how much wind and solar power you’re going to get more than five days, perhaps 10 days [out]. But you know, meteorologists have a limit of how strongly the wind is going to blow or whether it’s going to be cloud covering one area of the continent or not for solar, etc., etc.
So that variability created a lot of price volatility, particularly in the very short [end] of the short-term market. I mean, electricity used to be traded one year in advance, one month in advance. And these companies kind of specialize in trading the next 30 minutes of the electricity market. You know, mid-morning, what is going to be the demand for electricity by lunchtime? That’s what they specialize in.
But, you know, the five or six top of these companies were making perhaps $100 million combined. So not a lot. And they were in the rather of the industry, but not that … In 2022, they made $5 billion. The return on equity in many names of the industry went well above 100%. In some cases, well above 250%. So let me put it this way — the companies that were making a couple of million dollars were making $10, $25, $30 million.
The guys who were making $25, $30 million before were making a couple of hundred million dollars. And the guys who were making a hundred, they just went to a billion. It was just one of the biggest booms in commodity trading profitability I have ever seen. And the piece is about these names, which outside of the industry, basically no one really knows about.
3. Lessons From the Bear Market – Michael Batnick
We did a podcast in December of 2022 at the Nasdaq MarketSite in Times Square with our friends from the On The Tape podcast. At the time, things were…not great. Inflation was skyrocketing and the fed was chasing after it to slow down consumer prices.
The stock market was cratering. And the ones getting hit the hardest are the ones everyone owned. Amazon was 55% off its high. No really, 55%. Meta was worth just one-third of what it was in the previous year. Fear was everywhere.
I asked the audience, how many of you expect a recession in 2023? Every hand in the room went up. Then I asked, how many of you think the stock market bottomed in October? Crickets.
It’s easy to say “Be greedy when others are fearful.” It’s hard to actually do it…
…It’s easy to overestimate your ability to deal with downside risk when stocks are going higher. You only discover who you really are as an investor in bear markets.
Ben and I were getting dozens of emails about triple-leveraged ETFs in 2021: “I know it’s risky but I have a long time horizon.”
I don’t think we saw a single one of those messages hit our inbox (personal emails, personal responses) in 2022…
…I, like many of you, just kept buying over the last two years. It’s not because I’m a genius, and it’s definitely not because I was bullish with every purchase. I bought in my 401(k) every other week and in my brokerage account every month because it happens automatically. Out of sight out of mind.
If I had to physically log on and execute these trades, I’m sure that I wouldn’t be as consistent as I have been. You mustn’t let your emotions determine when you buy. Like Nick first said back in 2017, Just Keep Buying.
4. A beginner’s guide to accounting fraud (and how to get away with it): Part III – Leo Perry
If you’re looking for a role model for how to serially raise capital for a business that really shouldn’t even exist in the first place, you could do a lot worse than Avanti Communications. Avanti was a startup satellite broadband operator that issued half a billion odd of equity, and about as much again in debt, in just five short years. No one seemed to care much that the business case was flawed from the start. That revenue kept falling short and customers got less and less substantial. And, of course, it didn’t matter that the accounts read like a Stephen King novel. Because you can’t get a bigger addressable market than space, can you?
How did I know Avanti was always bound to end up failing its shareholders, even before it took off? The company said so. In black and white. It told me and every other investor that bothered to look at its 2009 annual report. I know corporate filings aren’t exactly gripping but it helps if you read them. Lucky for us, it doesn’t seem like many people do.
When I‘d asked directly, management had flat out refused to disclose what the Mb capacity of its first satellite (called Hylas-1) would be “for commercial competitive reasons”. But they soon went ahead and gave it away in a press release anyway, stating that 320Mb was about 10% of the total. From there it was simple to estimate build cost per Mb, which came in around £35mn. The problem was Eutelsat, which was about to launch its own broadband satellite over Europe too. This bird, KA-SAT, was 15 times as big but only cost about 3 times as much to build. It’s unit cost was more like €4mn per Mb. That was going to be an issue for Avanti.
Don’t take my word for it, take the company’s. In its 2009 annual report Avanti already states that Hylas-1 “will be full with around 200,000 – 300,000 end user customers”, with the higher number only possible if it delivered a lot of them something not much better than a Netscape dial-up service (as in 0.5Mb per second). But even then Eutelsat had a 3.6Mb per second product in the market, for €17 a month wholesale. And had said publicly it would be keeping that price point once KA-SAT was up, but for a 10Mb per second service. Hylas-1 was going to be competing with that, but at those speeds it would be able to serve a lot less customers. It’s not quite a straight line calculation because of contention – basically congestion from other users – but it wasn’t good news for Avanti. Commercial wholesale revenue for Hylas-1 would end up end peaking at around €15mn while sell side consensus was still “modelling” four times that.
5. Data Update 3 for 2024: A Rule-breaking Year for Interest Rates – Aswath Damodaran
As you can see, while treasury rates, across maturities, jumped dramatically in 2022, their behavior diverged in 2023. At the short end of the spectrum, the three-month treasury bill rate rose from 4.42% to 5.40% during the year, but the 2-year rate decreased slightly from 4.41% to 4.23%, the ten-year rate stayed unchanged at 3.88% and the thirty-year rate barely budged, going from 3.76% to 4.03%. The fact that the treasury bond rate was 3.88% at both the start and the end of the year effectively also meant that the return on a ten-year treasury bond during 2023 was just the coupon rate of 3.88% (and no price change).
I noted at the start of this post that the stock answer than most analysts and investors, when asked why treasury rates rose or fell during much of the last decade has been “The Fed did it”. Not only is that lazy rationalization, but it is just not true, and for many reasons. First, the only rate that the Fed actually controls is the Fed funds rate, and it is true that the Fed has been actively raising that rate in the last two years, as you can see in the graph below:
In 2022, the Fed raised the Fed funds rate seven times, with the rate rising from close to zero (lower limit of zero and an upper limit of 0.25%) to 4.25-4.50%, by the end of the year. During 2023, the Fed continued to raise rates, albeit at a slower rate, with four 0.25% raises.
Second, the argument that the Fed’s Fed Funds rate actions have triggered increases in interest rates in the last two years becomes shaky, when you take a closer look at the data. In the table below, I look at all of the Fed Fund hikes in the last two years, looking at the changes in 3-month, 2-year and 10-year rates leading into the Fed actions. Thus, the Fed raised the Fed Funds rate on June 16, 2022 by 0.75%, to 1.75%, but the 3-month treasury bill rate had already risen by 0.74% in the weeks prior to the Fed hike, to 1.59%.
In fact, treasury bill rates consistently rise ahead of the Fed’s actions over the two years. This may be my biases talking, but to me, it looks like it is the market that is leading the Fed, rather than the other way around.
Third, even if you are a believer that the Fed has a strong influence on rates, that effect is strongest on the shortest term rates and decays as you get to longer maturities. In 2023, for instance, for all of the stories about FOMC meeting snd the Fed raising rates, the two-year treasury declined and the ten-year did not budge. To understand what causes long term interest rates to move, I went back to my interest rate basics, and in particular, the Fisher equation breakdown of a nominal interest rate (like the US ten-year treasury rate) into expected inflation and an expected real interest rate:
Nominal Interest Rate = Expected Inflation + Expected real interest rate
If you are willing to assume that the expected real interest rate should converge on the growth rate in the real economy in the long term, you can estimate what I call an intrinsic riskfree rate:
Intrinsic Riskfree Rate = Expected Inflation + Expected real growth rate in economy…
…That said, it is remarkable how well the equation does at explaining the movements in the ten-year US treasury bond rate over time. The rise treasury bond rates in the 1970s can be clearly traced to higher inflation, and the low treasury bond rates of the last decade had far more to do with low inflation and growth, than with the Fed. In 2023, the story of the year was that inflation tapered off during the course of the year, setting to rest fears that it would stay at the elevated levels of 2022. That explains why US treasury rates stayed unchanged, even when the Fed raised the Fed Funds rate, though the 3-month rate remains a testimonial to the Fed’s power to affect short term rates.
It is undeniable that the slope of the yield curve, in the US, has been correlated with economic growth, with more upward sloping yield curves presaging higher real growth, for much of the last century. In an extension of this empirical reality, an inversion of the yield curve, with short term rates exceed long term rates, has become a sign of an impending recession. In a post a few years ago, I argued that if the slope of the yield curve is a signal, it is one with a great deal of noise (error in prediction). If you are a skeptic about the inverted yield curves as a recession-predictor, that skepticism was strengthened in 2022 and 2023:
As you can see, the yield curve has been inverted for all of 2023, in all of its variations (the difference between the ten-year and two-year rates, the difference between the two-year rate and the 3-month rate and the difference between the ten-year rate and the 3-month T.Bill rate). At the same time, not only has a recession not made its presence felt, but the economy showed signs of strengthening towards the end of the year. It is entirely possible that there will be a recession in 2024 or even in 2025, but what good is a signal that is two or three years ahead of what it is signaling?…
…If there are lessons that can be learned from interest rate movements in 2022 and 2023, it is that notwithstanding all of the happy talk of the Fed cutting rates in the year to come, it is inflation that will again determine what will happen to interest rates, especially at the longer maturities, in 2024. If inflation continues its downward path, it is likely that we will see longer-term rates drift downwards, though it would have to be accompanied by significant weakening in the economy for rates to approach levels that we became used to, during the last decade. If inflation persists or rises, interest rates will rise, no matter what the Fed does.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have a vested interest in Amazon and Meta Platforms. Holdings are subject to change at any time.
